COVID-19 has had a vast and varied impact on our economy. Unfortunately, in many ways nonprofits are bearing the brunt of a post-COVID economy characterized by tightening of wallets and reduced cash flow. Among the many unexpected challenges it has introduced, a post-pandemic economy could contribute to an unanticipated change of status for your nonprofit.
What is the Public Support Test?
There are five categories of IRC Section 501(c)(3) organizations (“501(c)(3)”) qualifying for Internal Revenue Service (IRS) benefits (namely, freedom from income tax and contributions that qualify for a charitable tax deduction). However, only public charities – the largest category of 501(c)(3) organizations – are subject to the public support test (“test”).
The test is designed to ensure that organizations classified as public charities have a broad and diverse base of funding and are truly supported by the public they’re designed to serve. This requirement positions public charities in contrast with private foundations, which generally have limited sources of funding.
To qualify as a public charity, nonprofits must meet one of two annually recurring tests conducted by the IRS:
- At least one-third of the total support from individuals, corporations and dues is made up of publicly sourced donations; or
- The services available to the general public, and the make-up of the board of directors, reflects that the nonprofit operates like a public charity with at least 10% of total support coming from individual, government or organizational sources (the facts and circumstances test).
The one-third support or the 10% support tests do not include aggregate donations from a single source of funding exceeding 2% of a nonprofit’s total support. Contributions from related parties are required to be aggregated into a single funding source for this test and includes entities owned by the same donor, private foundations funded by the donor and family members of the donor. Good record keeping is essential for complying with public support test disclosures.
Why Should I be Concerned About a Change in my Nonprofit’s Status?
For some organizations, it’s essential to maintain classification as a public charity. For others, the designation is less of an imperative. The importance of maintaining a designation as a public charity comes down to each organization’s unique goals versus the restrictions that the other four categories of 501(c)(3) impose.
Typically, an organization classified as a public charity that fails its public support test will be automatically reclassified as a private foundation. Private foundations can be operating or non-operating (depending on their mission and meeting statutory tests), are 501(c)(3) organizations like public charities and enjoy similar tax benefits. However, they do face some requirements or restrictions that public charities don’t.
In contrast to public charities, non-operating private foundations:
- Must distribute a portion of their income annually,
- Need to remain independent from major contributors (certain business relationships with major contributors can be considered “self-dealing” and subject to excise taxes),
- May be subject to penalties for risky investments or failing to distribute funds appropriately, among other regulatory requirements,
- Generally are subject to excise tax on investment earnings.
Finally, donors to private foundations are subject to limitations on federal income tax deductibility. A year of an individual’s contributions to a private foundation are deductible only up to 30% of their adjusted gross income for that year. Furthermore, contributions of appreciated property to private foundations are subject to their own deductibility limitations. It is important to consider these factors from the perspective of your donors. Will a change of status from a private charity to a private foundation make your donors less inclined to contribute?
How Might COVID Lead to a Change in Status?
Because COVID has limited cash flow throughout the economy, nonprofits may not be enjoying the diverse sources of funding that they have relied on in previous years. For example, if your nonprofit is meeting fundraising goals by increasing its reliance on fewer sources of funding issuing larger contributions, it may be in danger of failing an upcoming public support test.
Unfortunately, budget and staffing limitations within the nonprofit industry can make it difficult to recognize when your nonprofit’s status is in danger. In some cases this is not clear until the year-end has passed and the annual audit is already underway. This provides little time to affect the outcome of the test. These internal reporting issues, pronounced even in strong economies, have only been exacerbated in the current climate.
What Remedies are Available to Prevent a Change in Status?
Once the danger is recognized, there are several means of curing situations and strengthening a nonprofit’s chance of passing a public support test.
The simplest way may be to communicate your circumstances to major donors and amortize large donations over several years. When possible, let them know your situation and the maximum dollar value your nonprofit can receive without compromising your ability to qualify as a public charity. This requires a bit of preliminary legwork in predicting and modeling donations, but can save huge headaches down the road, while strengthening key relationships.
Note that the public support test is a rolling five-year test and careful planning should be employed to prevent single donor concentrations from “tipping” the organization into private foundation status. A review of the public support test should be performed annually as part of the 990 compliance preparation service.
Plan a fundraising strategy with the public support test in mind. It may sound obvious, but any public charities’ fundraising strategy should prioritize donations from as broad a base of support as possible. That may mean basing fundraising goals around diversity of donation sources, rather than their total dollar value.
Finally, take a look at the nature of each of your large donations. In some cases a large non-recurring donation can be excluded from the public support test. Often this exception applies in cases where a charity is named among the beneficiaries of a will.
If a public charity status is essential for your nonprofit to accomplish its goals, you need real-time insight into your funding. By paying close attention to your ability to meet the IRS’s public support test requirements, you will know when to take action and, using the actionable steps above, protect your status.
If you have any questions about your nonprofits’ ability to meet the public support requirement, contact a Friedman advisor today.